Chance and the Garden
Investing is an act of faith. We entrust our capital to corporate
stewards in the faith-at least with the hope-that their efforts
will generate high rates of return on our investments. When we
purchase corporate America's stocks and bonds, we are professing our
faith that the long-term success of the U.S. economy and the nation's
financial markets will continue in the future.
When we invest in a mutual fund, we are expressing our faith that the
professional managers of the fund will be vigilant stewards of the assets
we entrust to them. We are also recognizing the value of diversification
by spreading our investments over a large number of stocks and bonds.
A diversified portfolio minimizes the risk inherent in owning any individual
security by shifting that risk to the level of the stock and bond markets.
Americans' faith in investing has waxed and waned, kindled by
bull markets and chilled by bear markets, but it has remained intact.
It has survived the Great Depression, two world wars, the rise and fall
of communism, and a barrage of unnerving changes: booms and bankruptcies,
inflation and deflation, shocks in commodity prices, the
revolution in information technology, and the globalization of financial
markets. In recent years, our faith has been enhanced-perhaps excessively
so-by the bull market in stocks that began in 1982 and has accelerated,
without significant interruption, toward the century's end. As we approach
the millennium, confidence in equities is at an all-time high.
Chance, the Garden, and Long-Term Investing
Might some unforeseeable economic shock trigger another depression
so severe that it would destroy our faith in the promise of investing?
Perhaps. Excessive confidence in smooth seas can blind us to the risk
of storms. History is replete with episodes in which the enthusiasm of
investors has driven equity prices to-and even beyond-the point
at which they are swept into a whirlwind of speculation, leading to
unexpected losses. There is little certainty in investing. As long-term
investors, however, we cannot afford to let the apocalyptic possibilities
frighten us away from the markets. For without risk there is no
Another word for "risk" is "chance." And in today's high-f lying,
fast-changing, complex world, the story of Chance the gardener contains
an inspirational message for long-term investors. The seasons of
his garden find a parallel in the cycles of the economy and the financial
markets, and we can emulate his faith that their patterns of the past will
define their course in the future.
Chance is a man who has grown to middle age living in a solitary
room in a rich man's mansion, bereft of contact with other human
beings. He has two all-consuming interests: watching television and
tending the garden outside his room. When the mansion's owner dies,
Chance wanders out on his first foray into the world. He is hit by the
limousine of a powerful industrialist who is an adviser to the President.
When he is rushed to the industrialist's estate for medical care, he identifies
himself only as "Chance the gardener." In the confusion, his name
quickly becomes "Chauncey Gardiner."
When the President visits the industrialist, the recuperating
Chance sits in on the meeting. The economy is slumping; America's
blue-chip corporations are under stress; the stock market is crashing.
Unexpectedly, Chance is asked for his advice:
Chance shrank. He felt the roots of his thoughts had been
suddenly yanked out of their wet earth and thrust, tangled, into
the unfriendly air. He stared at the carpet. Finally, he spoke:
"In a garden," he said, "growth has its season. There are spring
and summer, but there are also fall and winter. And then
spring and summer again. As long as the roots are not severed,
all is well and all will be well."
He slowly raises his eyes, and sees that the President seems quietly
pleased-indeed, delighted-by his response.
"I must admit, Mr. Gardiner, that is one of the most refreshing
and optimistic statements I've heard in a very, very long time.
Many of us forget that nature and society are one. Like nature,
our economic system remains, in the long run, stable and
rational, and that's why we must not fear to be at its mercy....
We welcome the inevitable seasons of nature, yet we are upset
by the seasons of our economy! How foolish of us."
This story is not of my making. It is a brief summary of the early
chapters of Jerzy Kosinski's novel Being There, which was made into a
memorable film starring the late Peter Sellers. Like Chance, I am basically
an optimist. I see our economy as healthy and stable. It is still marked
by seasons of growth and seasons of decline, but its roots have remained
strong. Despite the changing seasons, our economy has persisted in an
upward course, rebounding from the blackest calamities.
Figure 1.1 chronicles our economy's growth in the twentieth century.
Even in the darkest days of the Great Depression, faith in the future
has been rewarded. From 1929 to 1933, the nation's economic output
declined by a cumulative 27 percent. Recovery followed, however, and
our economy expanded by a cumulative 50 percent through the rest
of the 1930s. From 1944 to 1947, when the economic infrastructure
designed for the Second World War had to be adapted to the peace-time
production of goods and services, the U.S. economy tumbled
into a short but sharp period of contraction, with output shrinking by
13 percent. But we then entered a season of growth, and within four
years had recovered all of the lost output. In the next five decades, our
economy evolved from a capital-intensive industrial economy, keenly
sensitive to the rhythms of the business cycle, to an enormous service
economy, less susceptible to extremes of boom and bust.
Long-term growth, at least in the United States, seems to have
defined the course of economic events. Our real gross national product
(GNP) has risen, on average, 3 percent annually during the twentieth
century, and 2.9 percent annually in the half-century following the end
of World War II-what might be called the modern economic era. We
will inevitably continue to experience seasons of decline, but we can
be confident that they will be succeeded by the reappearance of the
long-term pattern of growth.
Within the repeated cycle of colorful autumns, barren winters, verdant
springs, and warm summers, the stock market has also traced a rising
secular trajectory. In this chapter, I review the long-term returns and
risks of the most important investment assets: stocks and bonds. The historical
record contains lessons that form the basis of successful investment
strategy. I hope to show that the historical data support one conclusion
with unusual force: To invest with success, you must be a long-term investor.
The stock and bond markets are unpredictable on a short-term basis,
but their long-term patterns of risk and return have proved durable
enough to serve as the basis for a long-term strategy that leads to investment
success. Although there is no guarantee that these patterns of the past,
no matter how deeply ingrained in the historical record, will prevail in
the future, a study of the past, accompanied by a self-administered dose of
common sense, is the intelligent investor's best recourse.
The alternative to long-term investing is a short-term approach
to the stock and bond markets. Countless examples from the financial
media and the actual practices of professional and individual investors
demonstrate that short-term investment strategies are inherently
dangerous. In these current ebullient times, large numbers of investors
are subordinating the principles of sound long-term investing to the
frenetic short-term action that pervades our financial markets. Their
counterproductive attempts to trade stocks and funds for short-term
advantage, and to time the market (jumping aboard when the market
is expected to rise, bailing out in anticipation of a decline), are resulting
in the rapid turnover of investment portfolios that ought to be
designed to seek long-term goals. We are not able to control our investment
returns, but a long-term investment program, fortified by faith in
the future, benefits from careful attention to those elements of investing
that are within our power to control: risk, cost, and time.
How Has Our Garden Grown?
In reviewing the long-term history of stock and bond returns, I rely
heavily on the work of Professor Jeremy J. Siegel, of the Wharton
School of the University of Pennsylvania. This material is somewhat
detailed, but it deserves careful study, for it provides a powerful
case for long-term investing. As Chance might say, the garden represented
by our financial markets offers many opportunities for
investments to flower. Figure 1.2, based on a chart created by
Professor Siegel for his fine book Stocks for the Long Run, demonstrates
that stocks have provided the highest rate of return among
the major categories of financial assets: stocks, bonds, U.S. Treasury
bills, and gold. This graph covers the entire history of the American
stock market, from 1802 to 2008. An initial investment of $10,000 in
stocks, from 1802 on, with all dividends reinvested (and ignoring
taxes) would have resulted in a terminal value of $5.6 billion
in real dollars (after adjustment for inflation). The same initial
investment in long-term U.S. government bonds, again reinvesting
all interest income, would have yielded a little more than $8 million.
Stocks grew at a real rate of 7 percent annually; bonds, at a rate of
3.5 percent. The significant advantage in annual return (compounded
over the entire period) exhibited by stocks results in an extraordinary
difference in terminal value, at least for an investor with a time
horizon of 196 years-long-term investing approaching Methuselan
Since the early days of our securities markets, returns on stocks have
proved to be consistent in each of three extended periods studied by
Professor Siegel. The first period was from 1802 to 1870 when, Siegel
notes, "the U.S. made a transition from an agrarian to an industrialized
economy." In the second period, from 1871 to 1925, the United
States became an important global economic and political power. And
the third period, from 1926 to the present, is generally regarded as the
history of the modern stock market.
These long-term data cover solely the financial markets of the
United States. (Most studies show that stocks in other nations have provided
lower returns and far higher risks.) In the early years, the data are
based on fragmentary evidence of returns, subject to considerable bias
through their focus on large corporations that survived, and derived
from equity markets that were far different from today's in character
and size (with, for example, no solid evidence of corporate earnings
comparable to those reported under today's rigorous and transparent
accounting standards). The returns reported for the early 1800s were
based largely on bank stocks; for the post-Civil War era, on railroad
stocks; and, as recently as the beginning of the twentieth century, on
commodity stocks, including several major firms in the rope, twine, and
leather businesses. Of the 12 stocks originally listed in the Dow Jones
Industrial Average, General Electric alone has survived. But equity markets
do have certain persistent characteristics. In each of the three periods
examined by Professor Siegel, the U.S. stock market demonstrated
a tendency to provide real (after-inflation) returns that surrounded a
norm of about 7 percent, somewhat lower from 1871 to 1925, and
somewhat higher in the modern era.
In the bond market, Professor Siegel examined the returns of long-term
U.S. government bonds, which still serve as a benchmark for the
performance of fixed-income investments. The long-term real return
on bonds averaged 3.5 percent. But, in contrast with the remarkably
stable long-term real returns provided by the stock market, bond market
real returns were quite variable from period to period, averaging
4.8 percent during the first two periods, but falling to 2.0 percent during
the third. Bond returns were especially volatile and unpredictable
during the latter half of the twentieth century.
Stock Market Returns
Let's look first at the stock market. Table 1.1 contains two columns of
stock market returns: nominal returns and real returns. The higher figures
are nominal returns. Nominal returns are unadjusted for inflation.
Real returns are corrected for inflation and are thus a more accurate
reflection of the growth in an investor's purchasing power. Because the
goal of investing is to accumulate real wealth-an enhanced ability to
pay for goods and services-the ultimate focus of the long-term investor
must be on real, not nominal, returns.
In the stock market's early years, there was little difference between
nominal returns and real returns. In the first period (with its more
dubious provenance), from 1802 to 1870, inflation appears to have
been 0.1 percent annually, so the real return was only one-tenth
of a percentage point lower than the nominal stock market return of
Inflation remained at an extremely low level through most of the
nineteenth century. In the stock market's second major period, 1871
to 1925, returns were almost identical to those in the first period,
although the rate of inflation accelerated sharply in the later years.
Nominal stock market returns compounded at an annual rate of
7.2 percent, while the real rate of return was 6.6 percent. The difference
was accounted for by annual inflation averaging 0.6 percent.
In the modern era, the rate of inflation has accelerated dramatically,
averaging 3.1 percent annually, and the gap between real and nominal
returns has widened accordingly. Since 1926, the stock market has provided
a nominal annual return of 10.6 percent and an inflation-adjusted
return of 7.2 percent. Since the Second World War, inflation has been
especially high. From 1966 to 1981, for example, inflation surged to an
annual rate of 7.0 percent. Nominal stock market returns of 6.6 percent
annually were in fact negative real returns of -0.4 percent. More
recently, inflation has subsided. From 1982 to 1997, during substantially
all of the long-running bull market, real returns averaged 12.8 percent,
approaching the highest return for any period of comparable length in
U.S. history (14.2 percent in 1865-1880).
The high rate of inflation in our modern era is in large part the
result of our nation's switch from a gold-based monetary system to a
paper-based system. Under the gold standard, each dollar in circulation
was convertible into a fixed amount of gold. Under our modern
paper-based system, in which the dollar is backed by nothing more (or
less) than the public's collective confidence in its value, there are far
fewer constraints on the U.S. government's ability to create new dollars.
On occasion, rapid growth in the money supply has unleashed bouts
of rapid price inflation. The effect on real long-term stock returns
has nonetheless proved neutral. Even as nominal returns have risen in
line with inflation, the rate of real return has remained steady at about
7.0 percent, much as it did through the nineteenth century.
Excerpted from "Common Sense on Mutual Funds: Fully Updated 10th Anniversary Edition" by John C. Bogle. Copyright © 0 by John C. Bogle. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher. Excerpts are provided solely for the personal use of visitors to this web site.